The Bank for International Settlements has proposed that faltering “too big to fail" banks such as Australia’s big four lenders in the event of a crisis be wound up over a weekend and their assets carved up and sold, so that shareholders and creditors – not taxpayers – would incur the losses.

As part of the blueprint for recapitalising banks facing bankruptcy, management and board directors responsible for the failure could be sacked.

The instructive new BIS paper will give Australian regulators pause for thought as they consider implementing a new regime for domestic systemically important banks (DSIBs) and demanding that banks draw up so-called Living Wills.

“The mechanism can eliminate moral hazard throughout a banking group in a cost-efficient way that also limits the risk to financial stability," said the BIS paper’s authors, Paul Melaschenko and Noel Reynolds.

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“Expectations of government support can amplify risk taking, reduce market discipline and create competitive distortions, further increasing the probability of distress."

The proposal by the BIS, known as the bank for the world’s central banks, aims to provide certainty in situations akin to the catastrophic failure of Lehman Brothers in 2008 and the recent collapse of Cyprus’s banks, after which policymakers originally threatened to impose losses on insured depositors.

Hierarchy of claims would be respected

Under the BIS plan, shareholders and creditors whose claims were ranked below other bond holders in the failing bank’s capital structure would bear the brunt of the losses.

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The hierarchy of claims would be respected and any insured depositors must continue to be protected, the BIS said. In Australia, deposits of up to $250,000 are insured by the government.

The ownership of the bank would be transferred to a new temporary holding company. The bank would be immediately recapitalised by writing off claims of creditors over a weekend.

The holding company would then sell the recapitalised bank at market price and distribute the proceeds from the sale to the written-off creditors by strictly following the hierarchy of their claims as it existed before the point of failure was reached, the BIS said.

“The template is simple, fully respects the existing creditor hierarchy and can be applied to any failing entity within a banking group," the BIS said.

“The mechanism partially writes off creditors to recapitalise the bank over a weekend, providing them with immediate certainty on their maximum loss."

The potential ratings downgrade would not affect the banks’ most keenly observed AA credit rating for senior unsecured debt, which is the key rating that influences the cost of most of their funds sourced in international markets.

Burden-sharing principles

Sub-debt makes up less than 10 per cent of banks’ total funding.

Moody’s said the evolving international regulatory landscape made support for bank sub-debt less probable than before.

“Government policy has evolved towards the adoption of ‘burden-sharing’ principles, and gradually away from the automatic bailout of all creditors over the last few years," Moody’s Asia Pacific Financial Institutions managing director Stephen Long said in a statement.

Investors who buy sub-debt are lower down the pecking order than other creditors in a bankruptcy, but ahead of some other claimants including those who buy hybrids and shareholders.

“The willingness of [overseas] governments and regulators to apply burden-sharing principles and their ability to do so without causing contagion have been demonstrated in several recent cases where losses were effectively imposed on creditors along the entire credit hierarchy in order to recapitalise banks."

Since the 2008 global financial crisis, there have been 12 Moody’s rated subordinated debt defaults, including in Denmark, Ireland and Britain.

Shareholders and creditors in Dutch bank SNS Reall recently were forced to wear losses when the government took control of the bank.

Sub-debt for the big Australian banks is ranked by Moody’s one notch below Aa2 (AA) rated senior unsecured bonds. However, Standard& Poor’s has rated sub-debt three notches below its senior unsecured rating of AA- since November 2011, in the belief there would be no government support in Australian sub-debt in a crisis.

NAB senior analyst Ken Hanton said the potential downgrade of subdebt was not a big deal. “Ratings are a relative measure and banks’ subdebt around the world is being lowered, and it’s bringing Moody’s in line with S&P and Fitch," Mr Hanton said.

No deterioration in quality

Moody’s said the review of the banks’ sub-debt ratings was not related to any deterioration in the affected banks’ credit quality.

Subdebt previously made up almost half of Australian banks’ capital, or up to 4 per cent of risk-weighted assets under the Basel II capital regime.

But regulators have demanded common equity make up a greater share of capital under the new Basel III rules.

New subdebt securities also feature “bail in" features, where debt can be turned to equity and creditors take a “haircut" on the bonds.

Moody’s expects to conclude its review within the next three months.

Aquasia analyst Mark Bayley said the review was more to do with Moody’s changing its global rating methodology and the way it assesses the probability of government support in the event of a banking crisis.

“I would be more focused on Moody’s comments that the reviews of the banks’ sub debt ratings are not related to the banks’ fundamental credit quality," he said.

“Having said that it does highlight the issues of investing in banks at the moment with the rapidly changing government attitudes to implicit or explicit financial support."

“Aquasia’s own credit fund has generally avoided bank either senior or subordinated bonds for this reason."

Moody’s said that the many examples of losses being imposed on subdebt holders in the context of bank resolutions in other regions have lowered the probability that Asian authorities would feel obliged to support subordinated debt due to concerns about the risk of contagion.

“There would be little stigma attached to involving subdebt in burden sharing given these prior examples and given that the global regulatory consensus increasingly sees this as best practice," Moody’s said.